TANKING MARKETS: Here's Why It Might Be Different This Time

The stock market is on a tremendous, multiyear bull market,
though of course there have been a lot of dips along the way.

But something seems to be different about the recent sell-off in
stocks, which has pushed major indices down to levels not seen
since August.

Just over a week ago, Dan Greenhaus of BTIG wrote this about the
conversations he was having with clients:

What we find most interesting about the five session, 2.3% drop
in equity prices, is not the shallowness of the decline, nor its
length (or lack thereof). It was the speed at which
sentiment shifted from bullishness to bearishness.
Newspaper articles, television commentary and client interactions
all appeared to shift on a dime, suggesting that perhaps, just
maybe, people aren’t as comfortable in their bullishness as some
may assert. We find this interesting given the table below which
details exactly how positive the fourth quarter tends to be.

Why is this selloff causing such alarm? Or to put it another way,
why is the selloff different this time?

The answer may be found in the interest-rate environment.

To put it simply, signs exist all over the place that the market
is anticipating monetary policy to tighten in the not-so-distant
future, which is something we just haven't seen in the
post-financial-crisis environment.

Here, for example, is a chart of two-year interest rates. After
years of grinding lower and lower, they're now on a slow uptrend,
which most likely reflects the prospect of interest-rate hikes in
the cards sometime in 2015.

FRED

But that's
just part of the story.

Here's a chart
of five-year real interest rates (real interest rates are
calculated by taking interest rates on vanilla government bonds,
and then adjusting for inflation). After years and years of
declining real interest rates (meaning that inflation was running
hotter than the nominal yield), real interest rates are now
positive and appear to be trending higher. This is another sign
of tightening monetary policy.

FRED

Another chart
to check out is the 5-Year, 5-Year Forward Inflation Expectation
Rate, which is the market's expectation of what inflation will be
over the coming years. As you can see, inflation expectations
have been tanking lately.

This is ominous for the Fed, as inflation expectations are
starting to head toward levels below the Fed targets.

FRED

The upshot of all this is that monetary policy is tightening.
Interest rates are rising. Real interest rates are positive and
are rising. And inflation expectations are nosediving.

This is not
what we've seen in previous market sell-offs throughout this bull
market.

The market is
fearing a too-early tightening cycle that snuffs out inflation
(and possibly the recovery) before it even has the chance to get
anywhere.

In the past,
markets could be soothed by the belief that a tightening cycle by
the Fed was a long way out. Not anymore.